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Tuesday, December 20, 2011

A Global Shift from Equity to Debt?

The McKinsey Global Institute has an intriguing report out on "The emerging equity gap." The starting point is that listed equities are 28% of the $200 trillion or so in global financial assets in 2010, but are on track to drop to 22% of global assets by 2020.

This change isn't because stock market values are expected to melt down! Instead, it's mainly because growth in the world economy is happening in places like China and India and other emerging market economies where stock markets are not well-established. Households in those countries are much more likely to put their money in bank accounts, rather than in stock market funds. Businesses in those countries get their financing through debt markets: banks, bonds, and other loans.

What economic issues arise if stock markets don't expand with the economic growth in emerging markets? The McKinsey report explains:

"Expansion of equity markets has provided an important source of funding for companies; it has offered an exit option for venture funders who are so important to innovation; it ushered in a new era of corporate ownership and governance, as families and founders transferred control of companies to a diverse set of shareholders; and it has spurred greater competition within industry sectors and fostered faster entry and exit of firms through M&A and spin-offs. In most countries, equity investments have offered investors higher returns on savings over the long term than bonds or deposits, helping them to accumulate wealth and fund retirement. Reducing this enabler of dynamic performance will have implications for economic performance and global rebalancing. ...

"GDP growth rates could be slowed somewhat by a reduction in the relative role of equity funding and a rise in debt financing. Equities provide not only long-term funding, but also an important means of absorbing risk and dispersing it across many investors. During economic downturns, high levels of debt in the economy—in households, or in the corporate or government sectors—create a higher risk of bankruptcy. By contrast, companies that are financed with higher levels of equity have less risk of financial distress than those financed mainly with debt. The procyclical dynamic of high leverage exacerbates the depth of recessions, forcing more companies to cut back employment to meet debt payments and leaving more firms in danger of bankruptcy. In addition, over-reliance on debt financing may help fuel asset bubbles. When a downturn does occur, more diversified financial systems can withstand the strain better and can resume growth more rapidly because their companies are less indebted and have alternative means of raising financing. ...

Today, policy makers and economists continue to debate the relative merits of equity financing versus bank financing and there are certainly ample examples of countries that have sustained strong growth with limited equity markets: South Korea during its fastest growth phase, Germany, and recently China, for example. Current academic thinking suggests that the optimal financial market structure for a country depends on its stage of economic and industrial development: as economies advance, firms need larger and more robust equity markets to facilitate innovation and supply large amounts of capital for new industries. Empirical evidence suggests that if legal protections for shareholders are strong, financial systems that include robust capital markets—in addition to bank financing—promote faster economic growth than purely bank-based ones.

The broad outlines of a policy response to this issue are clear enough: emerging-market economies can start taking steps to develop their equity markets, and the financial sector can start figuring out how to make it easier for American and European investors to buy such equities. Both changes are likely.

Historically, as economies grow, they place a greater emphasis on stock markets: "Over the past century, there has been a clear pattern: with few exceptions, as countries have grown richer, investors have become more willing to put some money at risk in equities to achieve higher rates of return. We have seen this pattern not only in the United States and Europe, but more recently in Singapore,South Korea, and Hong Kong. However, other factors must also be in place for equity markets to thrive: rules and regulations that protect minority investors, transparency by listed companies, sufficient liquidity in the stock market, the
presence of institutional investors, and easy access to markets by retail investors."

If American investors as a group want to own a larger quantity of stocks over time, they will need to turn to stocks in emerging market economies. McKinsey explains: "In the United States and several other developed countries, investor demand for equities will most likely continue to exceed what companies will need because
many companies in these economies generate sufficient profits to finance investment needs. Indeed, US companies at the end of 2010 had more than $1.4 trillion in cash, and over the past decade nonfinancial corporations have been buying back shares, rather than issuing new ones."

Globalization isn't just about trade in goods and services. It's about financial flows and allocations of risks and returns across international borders as well. IMF data from its Coordinated Portfolio Investment Survey shows that international portfolio investment (that is, cross-border positions in debt and equity securities) rose from $6 trillion in 1997 to about $40 trillion in 2010. Bigger changes are coming.